Impermanent Loss

Providing liquidity to a decentralized exchange can earn you a share of trading fees, which sounds like an easy way to put idle crypto to work. But there is a hidden cost that surprises many beginners, and it has a confusing name: impermanent loss.

If you are thinking about adding funds to a liquidity pool, understanding impermanent loss is essential. It can quietly eat into your returns, even when the market is going up.

What Does Impermanent Loss Mean?

Impermanent loss happens when the prices of the tokens you deposit into a liquidity pool change compared to when you added them. The bigger the price change, in either direction, the bigger the loss. It is called a loss because you end up with less value than if you had simply kept the tokens in your wallet.

Imagine you and a friend run a fruit stand together, agreeing to always keep an equal value of apples and oranges on the shelf. If apples suddenly become very popular and expensive, customers buy up your apples and pay you in oranges. You still have a balanced stand, but you now hold fewer of the valuable apples than if you had kept them at home. That missed upside is impermanent loss.

How Impermanent Loss Happens

To understand impermanent loss, it helps to know how most decentralized exchanges work. Instead of matching buyers and sellers through an order book, many use automated market makers (AMMs). These rely on pools of two tokens supplied by users called liquidity providers.

The Pool Keeps Itself Balanced

A common AMM design uses a simple formula that keeps the product of the two token amounts constant. When traders buy one token from the pool, they add the other, which shifts the ratio and the price. If the price of a token rises on other markets, arbitrage traders buy it from the pool until its price matches. As a result, the pool ends up holding less of the token that went up and more of the token that went down.

A Simple Example

Say you deposit 1 ETH and 1,000 USDC into a pool when 1 ETH is worth 1,000 USDC, for a total of $2,000. To keep this simple, imagine you own the whole pool. Later, the price of ETH rises to 4,000 USDC. Arbitrage traders rebalance the pool until it holds about 0.5 ETH and 2,000 USDC, worth $4,000 in total.

If you had simply held your original 1 ETH and 1,000 USDC, you would have $5,000. The $1,000 difference, or 20%, is your impermanent loss. You still made money compared to your starting $2,000, just less than if you had done nothing. These numbers are only an illustration, not a prediction of any real price.

How Big Can Impermanent Loss Get?

In a standard 50/50 pool, the loss depends only on how far the price ratio moves from where it started, not on which direction it moves. Rough figures look like this:

• Price changes by 1.25x: Loss of about 0.6% compared to holding.
• Price doubles (2x): Loss of about 5.7%. The same loss applies if the price halves.
• Price triples (3x): Loss of about 13.4%.
• Price rises 4x: Loss of about 20%.
• Price rises 5x: Loss of about 25.5%.

Small price moves cause small losses, but large swings can make a serious dent, especially with volatile tokens.

Why Is It Called Impermanent?

The loss is only "impermanent" while your funds stay in the pool. If prices return to exactly where they were when you deposited, the loss disappears. However, once you withdraw at a different price, the loss becomes permanent. In practice, prices rarely return to the exact same level, so many people consider the name a little misleading.

Can Trading Fees Make Up for It?

Liquidity providers earn a share of the fees paid by traders who use the pool. In busy pools, these fees can offset some or all of the impermanent loss over time. Some protocols also offer extra token rewards through yield farming programs. Whether this is enough depends on trading volume, the fee rate, and how much prices move.

Keep in mind that reward tokens can lose value too. A pool advertising a high yield may still leave you worse off than holding if prices swing sharply or the reward token's price falls. Most pool dashboards show your current position, so compare it with what you deposited from time to time.

How to Reduce Impermanent Loss

You cannot avoid impermanent loss completely when providing liquidity to price-changing pairs, but you can manage it:

• Choose stable pairs: Pools of two stablecoins pegged to the same currency tend to have very little price divergence, which keeps impermanent loss low.
• Pick correlated assets: Tokens that usually move together, such as an asset and its wrapped version, tend to diverge less.
• Understand concentrated liquidity: Some newer AMMs let you provide liquidity in a set price range. This can earn more fees, but it can also increase impermanent loss if the price moves outside your range.
• Start small: Test with an amount you can afford to lose until you understand how a pool behaves.

Like all of DeFi, liquidity pools also carry other risks, including smart contract bugs and scams. Always research a protocol before depositing funds.

Useful Links

• What is decentralized finance?
• What is a liquidity pool?
• How to get started with decentralized trading?
• What are stablecoins?